The supply of money is what gives each dollar its value. All things being equal, the greater the supply, the lesser the value.
We can make the same conclusions about shares of stock. If a company announces a 2:1 split, what happens to the price? A 2:1 split just means that the company issues one share of stock for each share in existence thus creating two shares for every one in existence. If you own 100 shares today, you will have 200 shares after the split. Does that mean you’ll immediately double the value of your holdings? No, because the share price gets cut in half. In other words, if you double the number of shares, the price falls proportionately. Microsoft is currently trading for about $35 per share and has 9.38 billion shares outstanding. What would the company be worth if they increased the number of shares by a factor of 10,000? It would be nearly worthless. As with money, the more stock certificates there are in existence, the lower the value of each share.
Money has value because of the relative availability. If money were as plentiful as grains of sand on all the world’s beaches, it would have no value. Just like shares of stock, money is similar in that it symbolizes a claim on assets. If you have a ten-dollar bill, it represents your claim to ten dollars worth of goods or services. However, if that ten-dollar bill represents such a small fraction of all bills in existence, it is virtually worthless. In a similar way, one grain of sand represents an insignificantly small portion of the beach and therefore has no value.
At any time, the Fed can count the number of dollars in existence but that is easier said than done since that depends on what we’re willing to count as money. There are four basic definitions that the Fed uses to measure the supply of money called M1, M2, M3 and L. In fact, in the Federal Reserve booklet, The Federal Reserve System, Purposes & Functions, the Fed gives the following definition of money:
"Anything that serves as a generally accepted medium of exchange, a standard of value, and a means of saving or storing purchasing power. In the United States, currency (the bulk of which is Federal Reserve notes) and funds in checking and similar accounts at depository institutions are examples of money."
While it's beyond the scope of this course to go into the various pros and cons of the different measures, they are listed here just to emphasize how difficult it is to give a precise definition of the supply of money:
M1 is the base measurement of the money supply and includes cash in the hands of the public (currency and coins) plus demand deposits, tourist's checks from non-bank issuers, and other checkable deposits.
M2 is equal to M1 plus savings deposits, money market accounts, overnight repurchase agreements issued by commercial banks, overnight Eurodollars, money market mutual funds, and time deposits less than $100,000.
M3 equals M2 plus institutionally held money market funds, term repurchase agreements, term Eurodollars, and large time deposits.
L,the fourth measure, is equal to M3 plus Treasury bills, commercial papers, banker's acceptances, and very liquid assets such as savings bonds. Almost all short-term, highly liquid assets will be included in this measure called L, which stands for liquidity.
Regardless of how it is measured, an increase in the supply of money puts more spending power in the hands of the consumers, which stimulates demand for goods and services. The Treasury must issue enough securities to provide the amount needed by the economy and the money supply is ultimately limited by the total amount of Treasury securities outstanding.
Is there a limit on the demand for money? Could you ever have too much? While this may be the suggested meaning in the phrase demand for money it is not the way it is used by economists. When economists speak of the demand for money, they mean your desire to hold a given amount of money over a given time. There are three main reasons why people demand to hold money (1) to conduct basic transactions (2) for unexpected events, which is often called a precautionary motive, and (3) for speculation.
The first reason, transactions, refers to basic transactions. These include money for food, transportation, tolls, and other miscellaneous known transactions throughout a given time period. For example, if you typically hold an average of $100 in your wallet each week to conduct transactions, that's your transactions demand for money. Precautionary money is held for unexpected transactions such as car repairs or medical bills, although does not need to be limited to serious expenses or needs.
You could hold additional money to take advantage of a computer sale you expect to be happening soon. The speculation motive for holding money is a battle between cash and investments. Cash, by itself, earns no interest and can therefore be expensive to hold (due to the opportunity cost of foregone interest). However, if you think stock and bond prices are relatively low, you could generate a return on your money by putting cash into these investments – that’s the speculative motive for holding money. Conversely, if interest rates are high, you will want to hold as much cash as possible.
As stated at the beginning of this course, the supply and demand for any product or service is what determines its value and money is no exception. We also stated earlier that banks regulate the flow of money from lenders to borrowers. Now it's time to apply the principles of supply and demand and see how they coincide with bank operations.
If the bank desires more funds to loan, they must increase the interest rate (raise the bid) they pay for their products, such as Certificates of Deposit. As the price goes up, cash comes in. Likewise, if they have excess cash, they have more "sellers" of cash than "buyers." In other words, they have more lenders than borrowers so will likely lower rates to give consumers the incentive to borrow and lenders the disincentive to lend. Interest rates are therefore the price that people are willing to pay for the use of money. Specifically, interest is the price of current consumption. If you want to buy something now but do not have the money, you can borrow the funds from a bank. In exchange, you must pay back the money plus interest, which means there is something in the future you will not be able to purchase. You are effectively sacrificing that future good for another good today. Lenders are willing to sacrifice consumption of goods today in exchange for consumption of a higher amount (principal plus interest) of goods in the future. Economics is all about tradeoffs. Banks simply match lenders with borrowers.
How can we be sure there are not too many (or too few lenders) compared to the borrowers? By now you should understand that “price” acts to regulate the number of buyers and sellers. The price that regulates current consumption is the interest rate. How is that rate determined? Let's take a look at the mechanics.
If you have money to lend, you can, for example, buy a bond. You give up cash today to buy the bond. While it may sound a little confusing, if you are a buyer of a bond, you are also a seller of cash. The seller of the bond uses that cash today in exchange for giving up more cash tomorrow. The seller of the bond is therefore the buyer of cash. Now you should have a better understanding what was meant when we said supply and demand are two sides of the same coin. Suppliers of bonds are demanders of cash and vice versa.
If a lot of people want to borrow money relative to those who want to lend, then borrowers are trying to coax more cash out of the market. How do they create more sellers of cash? They do the same thing our desert tourists did when they wanted more water and raise their bid. As bond sellers raise the bid price of cash – the interest rate –more cash sellers (bond buyers) appear resulting in more cash emerging in the market.
We could have also reached the same conclusion by looking at the effects on bond prices in the markets. As the bond sellers compete for bond sales in the market, they must do so by lowering the price of bonds. Lower bond prices attract new bond buyers (sellers of cash). As bond prices fall, interest rates rise.
Remember, look at this situation as though you are either a buyer of cash or the seller of a bond. Either the price of cash goes up or the price of bonds goes down. Both result in higher interest rates.
The reverse effects obviously hold true as well. If we assume that a lot of people want to lend money relative to those who want to borrow, then we have more people willing to sell cash than those willing to buy and the interest rate should fall. We can run through the mechanics again as a quick check.
If you want to sell cash, you are effectively demanding the purchase of a bond. In order to sell cash, you must lower its price, which is the interest rate. Likewise you can view this as demanding a bond. How do you create more bond sellers? You raise the bid price of the bonds. As bond prices rise, interest rates fall.
As lenders buy bonds, they compete in the markets and drive up the price of bonds, which makes the interest rates (bond yields) fall. Therefore, if there are excess people willing to lend, interest rates will fall. In other words, there are more sellers than buyers so they must bring down their price in order to attract buyers.
Once all buyers of cash are equally matched with sellers, the market is cleared and the interest rate is stable. Just as any product or service's price is controlled by supply and demand, money is no exception. Money is a commodity and is subject to the same economic forces that establish price.
We should note that when people say "the" interest rate, they are generally talking about the short-term, risk-free rate on government treasuries, as there are many types of interest rates. Even within the government treasuries there are generally 90-day bills and 30-year notes with varying time frames in between. Regardless, any interest rate is the result of the current supply of money for that asset and the demand for it. What's the interest rate for credit cards? It is the price that equalizes the amount of money that banks are willing to supply for signature loans (loans that don't require collateral) and people's demand for that money. This should shed some light on consumers' willingness to spend ahead of their incomes and you hopefully now have at least a little different viewpoint if someone states that credit card rates are "outrageous." They are outrageous as a direct reflection of consumers’ insatiable appetite for spending today rather than tomorrow.
Interest rates are the tie between buyers and sellers of cash. By adjusting interest rates, we can control the incentives to buyers and sellers and therefore adjust the amount of cash available for loans. But this brings up an interesting point. Rather than regulating the amount of cash available to consumers, why doesn’t the government just print money for everybody thus making us better off? The answer, as shown in the next section, has to do with our economic forces of supply and demand.
Why Can't the Government Print Money and Make Everybody Wealthy?
We have seen that the value of everything is determined by its supply and demand for it. As we just found out, the same forces too determine the value of money. Many people wonder why the government can't just print money, deposit it into everybody's account, and make everybody wealthy. The reason is because there would be a large supply of money relative to the goods produced and the value of the dollar will fall.
People who make such arguments for printing money as a means for creating wealth are confusing money with wealth. If you think about it, you really don't desire money for the sake of holding additional pieces of paper. You desire it to purchase more things. The more things you are able to purchase, the wealthier you are. While most people associate more pieces of paper with the ability to purchase more things that is only true for an individual and not the group as a whole.
The mistaken belief that what is true for an individual is also true for the whole is known as the fallacy of composition. I may get a better view if I stand during a football game, but will lose that advantage if everybody else stands too. If I stick a fluorescent orange styrofoam ball on my car antenna, I have an advantage of quickly locating my car in a crowded parking lot – unless everyone else does the same thing. Likewise, you may be better off if you have more pieces of paper, but will lose the advantage if everybody has more too. Just because you own more pieces of paper does not necessarily mean you have more wealth.
If the government doubled overnight everybody's checking account balances, stock portfolios and other forms of money discussed earlier, you may think you would be pretty happy. Because of your newly found wealth, you will certainly demand more things. You will want another car, boat, more clothes, jewelry, and certainly more vacations. But here's the catch: none of these additional items were produced overnight. As you (and everybody else) rush out to buy them, the prices get bid up in the process because there are now more buyers than sellers. As we said earlier, people have a certain demand for money, and everybody tries to get rid of the excess cash. However, as you try to get rid of your cash, it becomes somebody else's cash.
Remember at the beginning of the course we showed several examples of where "lines of people" are formed when prices are too low. This is exactly what happens if the supply of money is increased. On a relative scale, there is more money than products so things appear a little cheap and people act accordingly and get in line to buy. The retailers cannot handle the excess demand so how do the get rid of the long lines of cash waiting outside their doors? They raise the prices to a point where they are in equilibrium and supply equals demand – to a point where prices are exactly doubled.
This phenomenon is often called the quantity theory of money. It states that a given money supply is spent over and over (called the velocity of money) on goods and services throughout the year. For example $1 can be spent on many items throughout the year, thus providing income to many people. The value of the number of products that dollar will buy is equal to Price * Quantity. In other words, $1 spent 10 times can support $10 worth of goods. This can be stated as:
Money Supply * Velocity = Prices * Quantity,
which can be written as:
M * V = P * Q
This is the formula behind the quantity theory of money. The velocity, V, of money is the rate at which people spend and is usually constant over fairly long periods of time. Likewise, the quantity, Q, of goods produced is fairly constant over a given time. Because V and Q are fairly constant, if the money supply, M, increases (left side of the equation), the only way the right side of the equation can balance is if prices, P, rise by an equal amount. In other words, if the money supply doubles so too will all prices.
So while the government does have the right and the ability to print more money, the economic forces of supply and demand prevent us from using printing presses to create true wealth. We can create more pieces of paper but you’d find that you are no better off than before. The reason is that prices will be proportionately “inflated” by the amount of cash in the system.
On our website, we feature this note worth 500 billion Yugoslavian dinars as a banner ad for this course. That's a 5 followed by 11 zeros! That's a lot of pieces of paper but it represented little value. Although, this currency is no longer, it was still nearly worthless when it was in existence. The Yugoslavian government used printing presses to pay off all its loans. The result was a lot of money without corresponding goods and services to back it up. The quantity theory of money states that the result will be inflation -- and that's why you see so many zeros. Let’s take a closer look at the monetary phenomenon of inflation in the next section.
